Main Street Meets Wall Street: The Mortgage Meltdown

Although Wisconsin’s housing market did not overheat in recent years as the housing markets did in California, Nevada, and other areas, it is a mistake to view the meltdown and related mortgage foreclosures as someone else’s problem. The authors explain the factors on Main Street and Wall Street that led to the subprime mortgage meltdown and survey the resulting litigation fallout in Wisconsin and elsewhere.

he woes facing the subprime mortgage market seem to affect every corner of our economy: Milwaukee-based MGIC faces a $500 million loss on a jointly-owned subprime investment;1 Merrill Lynch has posted an $8 billion loss;homeowners are bringing class-action lawsuits in the Eastern District of Wisconsin;2and foreclosures are rising in cash-strapped areas.3 How is an $8 billion loss on Wall Street tied to foreclosures in poor areas? What is the fallout in Wisconsin from these losses? This article explains the factors on Main Street and Wall Street that led to the subprime mortgage meltdown and surveys the resulting litigation in Wisconsin and elsewhere.

The Many Causes of the Mortgage Meltdown

The subprime mortgage meltdown was not caused by just one factor. Alone, increased demand for homes, low interest rates, risk-shifting investment vehicles, aggressive or fraudulent lending, creative financing, or lax oversight would not have caused the collapse. Together, however, these factors shifted priorities in the mortgage market, and then caused the mortgage problems that are at the forefront of the news.

Main Street Housing Booms and Subprime Loans. The ingredients for the mortgage meltdown started in the mid-1990s. The United States experienced a housing boom partly fueled by the reduced costs of loan financing. Banks made home ownership more widely available by lowering down-payment requirements from the historical 20 percent of home value to as little as 0 percent (often through use of second mortgages called "piggy-back loans").4

The real estate boom continued to gain steam at the turn of the century. After the stock market collapse in 2001 and the subsequent interest rate reductions by the Federal Reserve, people began to look for new investments. Home ownership increased as low interest rates, rising real estate values, and minimal financing requirements made owning a home seem like "merely another manageable asset in one's portfolio."5 A record number of people owned homes by 2004. The number of "investment homes" also increased.6

Rising property values decreased the risk that a cash-strapped buyer or a foreclosing lender would have to sell property at a loss. Mortgage lenders felt more comfortable lending money to high-risk or "subprime" borrowers. Many middle class borrowers with strong credit began to seek riskier financing (traditionally considered subprime) in order to buy homes in overheating markets.

These "subprime loans" were not new. Historically, banks offered subprime loans to borrowers who were considered high-credit risks for a variety of reasons, including borrowers having payment delinquencies, bankruptcies, job instability, high debt-to-income ratios, and low Fair Isaac & Company (FICO) scores.7 The traditional incentive to make subprime loans was simple: in exchange for taking on a higher risk of default, banks charged higher fees and potentially made more money up front and over the life of the loan. Consequently, most subprime loans have higher interest rates, higher fees, and higher loan-to-value ratios.

Securitization: Main Street Connects to Wall Street. As the demand for subprime mortgages increased, a new mortgage-lending business model took hold. Under the old model, banks used their own deposits to back their mortgage loans, holding the mortgages until they were repaid. Now mortgage lending companies lend money to subprime borrowers using money borrowed from Wall Street investment banks.8 The mortgage lender (also called the originator) repays the Wall Street loan when it sells the residential mortgage in a process called securitization.

At its best, securitization increases the number of people who can buy a home. In fact, the federal government started and encouraged the securitization process to increase the number of mortgage loans. At its worst, securitization shifts default risk away from those who can best assess it, encourages lenders (and the brokers they hire) to write risky loans, and leads to fraud.

To securitize subprime mortgages, mortgage lenders (also called mortgage originators) sell mortgages to Wall Street investment banks or transfer them into their own subsidiaries created to facilitate mortgage securitization. The Wall Street banks or lenders' subsidiaries sell the principal and cash flow generated by the pools of mortgages as a bond. These bonds are called mortgage-backed securities.

Until recently, securitization of residential subprime mortgages by private entities seemed to benefit everyone. Lenders flush with money borrowed from Wall Street, and able to spread risk among a wide pool of investors, could offer subprime loans to borrowers who did not qualify for or did not want traditional mortgages. Real estate investors, first-time borrowers, or cash-strapped home buyers could use the subprime loans to buy the property they wanted. Lenders earned money from the high fees associated with subprime loans. Wall Street banks earned fees on the sale of bonds. Bond investors earned large returns from the high yields created by pools of high-interest rate subprime loans. Consequently, the number of subprime loans soared.9 In 2006, subprime loans totaled $600 billion, 20 percent of all mortgages, up from $34 billion and less than 5 percent of all mortgages in 1994.10

Other Factors Add Risk to the Market. The incentives to market, enter into, and invest in subprime mortgages increased risk in the mortgage market in several respects.

In hindsight, the ability to sell subprime mortgages to Wall Street conditioned lenders and their brokers to ignore default risk. Under the old business model, the incentive to offer subprime loans with high fees was tempered by the risk of borrower default. (Recall that the bank lenders that offered subprime mortgages held them on their balance sheets until they were repaid.) Under the new business model, the lenders reaped the reward of high-fee subprime loans but sold the risk of borrower default to Wall Street banks.

Securitization also encouraged the growth of creative financing. Lenders and their brokers earned additional fees by offering borrowers subprime mortgages with low initial rates. Borrowers wanted low rates to lower monthly mortgage payments, which, in turn, allowed the buyers to afford a house or a more expensive house. The most common creative financing tool was (and is) the adjustable rate mortgage (ARM). ARMs are loans for which the interest rate moves up or down based on an index, such as the Consumer Funds Index (CFI), at preset intervals.11 ARMs with low initial rates have the added benefit of offering a more predictable flow of cash for investors than do fixed-rate loans that borrowers might seek to refinance when interest rates go down.12 Lenders and brokers did not always ensure that borrowers could avoid default when rates adjusted upwards.

Securitization involved another element of risk. Investors understood that if borrowers repaid all (prepayment) or part (curtailment) of their loans early, the yield from a mortgage-backed security would decrease. Investors would not pay as much for bonds backed by mortgages that could be repaid before all of the anticipated interest was paid. Thus, to make their mortgages attractive for investors, lenders sold mortgages with prepayment penalties. Many loans combine ARMs and prepayment penalties. When interest rates started rising, borrowers learned that they had to choose between paying a penalty to refinance an ARM or accepting a higher interest rate.

Lenders also loosened underwriting standards. Given the dilution of risk through securitization, lenders and brokers had fewer incentives to carefully document and underwrite loans. This led to mistakes and even to fraud. In some cases, brokers sold loans without following normal underwriting practices, pumped up property appraisals, and faked mortgage applications, W-2s, and other income-verifying documents.13

Loosened lending standards proved too tempting for many buyers. Some lied about their incomes to win mortgage approval (called "fraud for purchase"), misrepresented the origin of their down payments, secured multiple mortgages on the same property before anyone ran a title search on the first of those mortgages (buying and selling "in the gap"), and so on.14 These underlying practices threatened the soundness of many mortgage-backed bonds.

Theoretically, the large credit-rating agencies (Moody's Investors Service, Fitch's, and Standard & Poor's) could have helped stop Wall Street investors, lenders, and borrowers from heating up the residential mortgage market.

Rating agencies are paid by underwriters to rate bonds, including the mortgage-backed bonds discussed here. Because a subprime mortgage-backed bond carries the double risks of higher default rates and changeable interest rates, as well as valuation difficulties due to potential early repayment of mortgages, a low rating might be appropriate. Instead, for years the rating agencies gave many mortgage-backed securities high ratings. These high ratings are now a source of controversy, and one lawsuit already has been filed against Moody's alleging that it misstated the strength of some bonds it rated.

But, high ratings in hand, the Wall Street investment banks sold mortgage-backed bonds to yield-hungry investors. Those investors, which included hedge funds and pension funds and many foreign investors, either did not know or did not understand that many of their highly-rated investments could be made up of risky or fraudulent mortgages. They found out when borrowers began to default.

The Meltdown. In 2005 and 2006 interest rates rose. Borrowers defaulted on risky loans. The securitization process started to work in reverse - the meltdown began. The ratings agencies lowered ratings on mortgage-backed securities. Investors started withdrawing money from the investments created by Wall Street investment banks. Bond trustees looked to mortgage insurers like MGIC to pay on the defaults. Wall Street refused to purchase mortgages or lend money to mortgage lenders. Banks that had purchased pools of loans to hold or securitize began to exercise their contractual right to demand that the primary lenders repurchase the loans.

Of course, Wall Street affected Main Street. Lenders, with no Wall Street cash available, offered fewer loans and fewer opportunities to refinance high-rate loans and ARMs.15 The housing boom became a housing bust.16

The Litigation

This meltdown is generating a diverse collection of lawsuits and arbitration claims. Borrowers have sued their lenders, and other lenders are seeking compensation for bad loans from the brokers who placed them. Investors in mortgage-backed securities have filed claims alleging that misrepresentations were made in the marketing of those products, while some purchasers of the stock of mortgage lending companies claim those companies did not properly disclose the poor performance of the loans on their books. One plaintiff has sued a rating agency that evaluated the quality of mortgage-backed securities, and more such suits may follow.

Very broadly, these claims can be broken down into two categories: litigation over the way subprime loans were made in the first place, and litigation over the marketing of the securities that are backed by those loans. An examination of some of the lawsuits and arbitration claims that already have been filed may provide some insight into what is yet to come.

The Originators. Faced with ARMs readjusting more significantly than borrowers claim they expected, fees they did not understand, and other loan practices they believe were unfair, borrowers have filed class action lawsuits against the banks and brokers who signed them up for mortgages and even against the secondary lenders who financed those banks and brokers.

One of those lawsuits is pending in the Eastern District of Wisconsin.17 In 2005, Susan and Bryan Andrews filed suit against Chevy Chase Bank, FSB, seeking to represent a class of borrowers who entered into mortgages with that bank. The Andrews' complaint claims that Chevy Chase violated the Truth in Lending Act by including language and other information in its loan documents indicating that borrowers would receive a low introductory interest rate for five years, when in fact that rate was fixed for only the first month of the loan. The plaintiffs seek remedies that include the right for any class member to rescind its mortgage - a severe penalty that would require Chevy Chase to refund all interest and fees that each rescinding borrower has already paid.18

The court largely sided with the plaintiffs and earlier this year granted summary judgment awarding the right to rescind and attorney fees.19 In the same decision, the court certified a class consisting of all persons who obtained an ARM from Chevy Chase for a primary residence between April 30, 2004 and Jan. 16, 2007, and who received Truth in Lending Act disclosures with language identical to those the Andrews received, potentially granting a right to rescind to a wide swath of borrowers.

The defendants have appealed the Andrews decision to the Seventh Circuit, where oral arguments are complete and a decision is pending. The case presents an opportunity for the Seventh Circuit to begin developing consensus with other federal appellate cases or to strike out in a different direction. Although several federal district courts have held class actions in Truth in Lending Act rescission cases to be appropriate,20 the two federal appellate courts that have considered the matter have held that class certification is not available for rescission under the Truth in Lending Act.21

In another case involving allegations of abusive sales tactics by a mortgage lender, the Ninth Circuit upheld a verdict holding the lender's financing source responsible for aiding and abetting those tactics.22 In that case, subprime lender First Alliance went out of business after facing widespread scrutiny of its lending practices, which called on loan officers to carefully follow a script calculated to obfuscate the fees, points, interest rates, and other characteristics of refinance loans.

A lawsuit was filed on behalf of a class of First Alliance's borrowers against Lehman Brothers Inc., which provided a line of credit to enable First Alliance to make loans and provided underwriting of the bonds that First Alliance eventually issued secured by those loans. The Ninth Circuit upheld the jury's determination that Lehman Brothers had aided and abetted First Alliance's practices, because internal reports demonstrated Lehman Brothers had actual knowledge of those practices and had provided First Alliance with substantial assistance by providing the financing that kept First Alliance in business.23

Borrowers are not the only claimants seeking to hold loan originators liable for careless or fraudulent lending practices. Faced with rising default rates, secondary lenders are seeking to enforce their contractual rights to force the primary lenders and mortgage brokers who sold them groups of mortgages to repurchase those loans and reassume responsibility for them. These claims, often made in arbitration proceedings rather than in court, challenge the accuracy of the information submitted to the lenders concerning the borrower's finances, assets, credit history, and even identity. The claims do not necessarily allege fraud on the part of the brokers - though such fraud may well be present - but rather rely on provisions in the broker agreements in which the brokers warrant that they have verified all information in the loan application. Although these broker agreements are typically lender-friendly, the lenders bringing claims under them may experience a pyrrhic victory. Many brokers facing these arbitration claims have few tangible assets and their insurance has proven insufficient to satisfy awards.

The Investors. Borrowers and lenders are not the only parties getting headaches from subprime mortgage loans and the defaults they have generated. Investors in mortgage-backed securities and investors in mortgage banks have seen the value of their investments drop precipitously in recent months. Not surprisingly, these declines have led to a spate of securities-related litigation.

Not all of these lawsuits are based on securities laws. For example, several plaintiffs recently have filed lawsuits against State Street Bank and Trust Co. and its subsidiaries under the Employee Retirement Income Security Act (ERISA).

One of these plaintiffs, Prudential Retirement Insurance and Annuity Co., serves institutional retirement plan sponsors.24 Prudential allows these clients to invest in a variety of mutual funds and collective bank trusts, including two State Street bond funds that suffered considerable drops in value earlier in 2007. Prudential claims that State Street took a significant position in highly-leveraged and risky mortgage-related financial instruments, deviating from its announced low-risk investment strategy. Prudential argues that this change in investment strategy violated ERISA, because State Street was an ERISA fiduciary and violated its duty to act with appropriate care, skill, prudence, and diligence.

Another plaintiff, Unisystems Inc. Employees Profit Sharing Plan, has filed a similar suit on behalf of a class of all qualified ERISA plans, and their participants and beneficiaries, who invested in various State Street bond funds during a period of time in 2007.25

Much of the pending litigation under federal securities laws involves mortgage lenders and related companies, including companies that financed and securitized those mortgages, whose stock value tumbled after they disclosed the extent of their investments in poorly-performing subprime loans. One such case is the In re New Century securities litigation currently pending in the Central District of California.26 Another involves the Radian Group Inc., a global mortgage insurance and financial services company whose stock declined after Radian disclosed heavy losses in a mortgage credit joint venture in which it held a 46 percent stake.27 Radian's partner in that joint venture is Milwaukee-based Mortgage Guaranty Insurance Corp. (MGIC), which recently called off a planned merger with Radian in light of their joint venture's financial difficulties.28

From a different angle, the Teamsters Local 282 Pension Trust Fund filed a case earlier this year in the Southern District of New York, alleging that Moody's Corp. misrepresented the quality of the subprime-mortgage-backed securities for which it provided credit ratings.29

One particular constellation of cases, pending in the Eastern District of New York, sheds light on the array of securities allegations that might be made against trusts, mutual funds, hedge funds, and other entities that have invested heavily in risky mortgage-backed securities. Those cases involve American Home Mortgage Investment Corp., a real estate investment trust that invested in mortgage-backed securities generated by the securitization of mortgages that other American Home Mortgage subsidiaries originated and serviced. After American Home announced that it would stop making dividend payments, sparking a drastic fall in its stock price, plaintiffs sued American Home and its underwriter, auditor, and various officers and board members on behalf of investors, claiming that the defendants signed off on an array of inaccurate statements in American Home's prospectus materials. American Home has now sought Chapter 11 bankruptcy protection.

While the operative complaints in the American Home litigation soon will be amended and, no doubt, expanded, they outline the statements the plaintiffs allege were inaccurate. These include statements regarding: 1) the quality of the mortgages in American Home's portfolio and the resulting credit risk; 2) borrower income, assets, and credit scores and the care with which American Home confirmed them; 3) the methodology American Home used to value its holdings; 4) the rate of payment delinquencies it was experiencing; 5) its revenue flow; and 6) the nature of its debt.30 American Home and its subsidiaries, in turn, have sued Bank of America for allegedly reneging on a deal to guarantee against losses if American Home was forced to sell mortgages in its portfolio at a loss.31

These sorts of allegations - concerning representations about quality, valuation, and management of securitized mortgage debt - may well underlie a host of additional securities and ERISA lawsuits in the future.

Conclusion

Wisconsin's housing market did not overheat in recent years as the housing markets did in California, Nevada, and other areas, leading many people in Wisconsin to view the meltdown and related mortgage foreclosures as someone else's problem. Still, mortgage foreclosures in Wisconsin during the first four months of this year ran 23 percent ahead of the same period last year, and Wisconsin is home to many of the same types of mortgage brokers, financial services companies, institutional investors, and investment advisors that already have become embroiled in litigation in Wisconsin and elsewhere. The country's mortgage woes might not bypass us.